The Lost Decade

Today marks the 10th anniversary of the date of my best-ever brokerage account statement. The NASDAQ peaked on March 10, 2000. According to the February, 2000 statement I was a bloody genius!

In fact, they could have just addressed the statement to “Resident Genius” at my street address and I wouldn’t have had any trouble knowing who it was for.

It’s been a long ten years!

The pundits are calling it “the lost decade”, at least for stock investors. According to a report in this week’s Economist, Treasury Bills have outperformed the S&P over the past 10 years.

But some people made a lot of money over the past decade. They weren’t the buy-and-hold stock investors. They weren’t the buy-and-hold bond or currency or real estate investors either.

For the most part, the people who made a lot of money over the past 10 years have been those who have taken simple financial ideas and products and created highly complex financial products and markets from them. Particularly those who were able to do so utilizing massive amounts of leverage.

The idea of a sub-prime mortgage is simple. Creating a market based on the theory that a whole lot of sub-prime paper, carved up and leveraged smartly would produce AAA securities, was brilliant. Getting the government to essentially REQUIRE that these deals be done was genius—until it wasn’t, which didn't take long.

The ideas behind credit default swaps and collateralized debt obligations are not terribly complex but when the pricing of risk is based on horribly flawed measurements of it and, again, there is strong incentive to massively over-produce these instruments, the risk to the financial system is understated on an equally massive basis.

It’s perilous enough that market participants were given the incentive to produce huge quantities of complex and relatively illiquid assets. But when the government, in its dubious wisdom and false caution, mandated mark-to-market rules for major players in these illiquid assets, they nearly guaranteed that a meltdown would occur at SOME point.

When the markets for relatively illiquid assets freeze-up, as they all do from time to time, the issue of valuation becomes a very difficult one. When the small, or off-market, or marginal, or forced transaction becomes the only benchmark for assigning value to huge pools of assets, the result is a price graph that looks like the side of a cliff. And when other assets are derivatives of the one whose graph looks like that, the dominoes really start to fall.

What’s my point?

As has been well demonstrated by a number of analysts over the past year or so, the mathematics of risk measurement on which the last ten years of financial engineering has been based, was flawed. The fact that the occurrence of a particular event is highly improbable does not mean that it is impossible. And it does not mean that its risk can be ignored. People win the lottery every day. The highly improbable happens all the time.

Some people (relatively few) made a whole lot of money over the past 10 years on the theory that financial instrument risks were being appropriately measured. When it turned out that they were not, the economy as a whole very nearly imploded and we and our children will be paying the price for that for many years to come.

Here’s my point.

It has been shown that it is extremely difficult to accurately assess the risk of the sort of highly complex financial structures and instruments that have proliferated in the past decade. In fact, some say that it is impossible to foresee all of the ways in which some of these structures can go bad. And if we can’t foresee a risk it’s awfully hard to protect against it.

The creation of an invoice is a simple financial transaction. The structure of the obligation is straightforward. The mechanics of its fulfillment are straightforward.

The purchase of an invoice is a little trickier but still, in the scheme of financial transactions, pretty simple. The risks involved can be itemized with some assurance and the assessment of those risks does not require rocket science or rooms-full of PhDs with access to supercomputers.

Buying an invoice is essentially a low-tech financial transaction. But the pool of invoices created each year is enormous.

The traditional participants in the market have managed only minimal penetration.

But there is now a means of participating in that market in a way that is simple, efficient and scalable: courtesy of The Receivables Exchange.

TRE is not where it needs to be yet to absorb a great deal of capital. It has a lot to do before it becomes a real player in the big-money financial markets. But it’s still early days.

All things being equal, TRE offers the potential of size and simplicity as opposed to the sort of size and complexity that have caused such problems recently. After the past 10 years, SIMPLE sounds pretty good to me.

But, then, I’m not the genius I was 10 years ago!